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Sin and Unsinn

November 2, 2013 4:35 pmNovember 2, 2013 4:35 pm

Continuing on my German theme: Matt O’Brien catches something that I’d missed
— and it’s really, really bad. I’ve mentioned before that the European Commission’s
estimates of the structural rate of unemployment in troubled economies are disastrously misleading. Its model (pdf)
just isn’t designed to cope with sustained slumps that put some countries into near- or actual deflation, where the downward stickiness of nominal wages becomes a crucial issue. What the model does in such
cases is interpret the failure of these countries to experience accelerating deflation as a rise in the structural rate of unemployment.

A man from Mars, or from 1970, might look at this and say that it looks as if high unemployment does dampen wage changes in Spain, and that if we think that Spain can afford something like 3 percent annual wage growth,
it can run an economy with something like 15 percent unemployment. That’s not good — it’s a lot of structural unemployment, and it does say that Spain in the bubble years was way overheated.
But it’s nothing like the EC estimate, which says that the vast bulk of the rise in Spain’s unemployment rate is structural (NAWRU is non-accelerating-wage-rate-of-unemployment):

Photo

Credit European Commission

Where does this come from? Basically because the EC’s methodology says that if the NAWRU was 15, Spain should now be experiencing not just deflation, but accelerating deflation. Since this isn’t happening,
the structural unemployment rate must be close to the actual rate, and must have surged since the crisis began.

OK, this is crazy — and even the Commission’s staff realizes that it’s crazy. Furthermore, it matters, because by assuming that Spain has ridiculously high structural unemployment, the Commission
ends up demanding far more austerity than is justified even on its own criteria.